The Current Crisis — Causes and Consequences
Source: Adrian Day's Global Analyst (10/17/08)
Adrian Day’s reputation for discovering big winners adds credibility to the global investing pioneer’s insights, which he is sharing with The Gold Report via excerpts from recent articles in Adrian Day's Global Analyst. Acknowledging what trying times these are for investors, in this first segment of a five-part series, Day discusses what led to the current economic crisis and how he sees Washington’s $700 billion (and counting) bailout playing out.
The Current Crisis—Causes and Consequences
The house of cards built on easy credit has finally come tumbling down, triggered by the failure of one of the most flimsy of the cards, subprime mortgages. We’ll look at the causes—it’s important to understand causes if one has any reasonable chance of analyzing the present and assessing the outlook—and weigh the likely outcome of the government’s actions.
Not to keep you in suspense any longer, we believe the bailout and associated actions, adding yet more credit to an economy already over-ripe with easy credit, far from solving the problem (i.e., getting banks to lend again), will make matters ultimately worse, by postponing the necessary adjustments, building up inflation, and destroying the dollar and its purchasing power, devastating savers and undermining the foundations of the economy.
This will be a protracted slowdown as corporations and households de-lever and attempt to restore some health to broken balance sheets. Nevertheless—to jump ahead to the critical conclusion for investors we’ll discuss next time—we are far beyond the time for wholesale liquidation, if it means selling quality companies well below their intrinsic values. It may be too early for aggressive across-the-board buying, but remember the words of the late, great John Templeton, who advised us to “buy at the point of maximum pessimism.”
What Brought Us Here?
It is critical to start by analyzing the causes of the problem, and assessing the likely outcome. Only by understanding that, can we hope to know what to do. So what brought us here, and what’s next? The root cause of our current problems is clear: excess credit creation over these many years. Too much money and artificially low interest rates always and inevitably lead to speculation and mal-investment. Whatever excesses there have been on Wall Street—and there have been many, as well as the abject ignoring of any sense of fiduciary responsibility—nonetheless, blaming “Wall Street speculators” for the mess is a little like blaming a drunk child when the parent left the open bottle in the playpen.
Critical to understand is that this is not a normal cyclical downturn. Such is triggered by tightening money and higher rates in a deliberate attempt to cool an “overheated” economy and restrain inflation. The resulting recession can be sharp but is typically short. Similarly, it is relatively easy to get out of a cyclical recession: do the opposite of what triggered it, that is, ease money and lower rates. But this is not a cyclical downturn; it is, rather, a secular de-leveraging contraction. Tighter money and higher rates did not trigger it, and easing money and lowering rates will not get us out of it. Au contraire. We currently have easy money and low rates, rates that are actually negative at the short end. And easier money and even lower rates, such as we’ve seen over the past year, have not helped. (Indeed, despite the Fed slashing the overnight loan rate from 5¼% to 2% in the seven months to April, rates in the real market—mortgage rates, credit card rates, etc.—actually increased and, of course, available credit contracted.) This is important to recognize.
Selling Begets Selling
Thus, this de-leveraging process is likely to be a protracted process as banks, other firms, and households restore health to their balance sheets. But such a process feeds on itself, as we have all-too-painfully seen this year. Companies sell assets to raise capital, which pushes down prices, which forces others to raise capital, pushing prices down further, which causes banks to contract credit. And as banks contract, small businesses have difficulties, reducing purchases, and so on. So much of the selling in the market has been forced (by financial companies needing to raise capital to meet ratios; by investor receiving margin calls, and funds getting redemptions). The waves of forced selling then cause panic among investors, leading to the very worst kind of selling, blind liquidation of thinly traded securities into down markets. This can, and has, driven prices down sharply and suddenly.
Will the Bailout Work?
The banks have no capacity or appetite for lending, which is why lower rates haven’t helped. And why, given that for investment banks to reduce their average leverage from 30 times to 20 times would require that $6 trillion of assets be sold, the government’s $700 billion bailout won’t change the picture either. (Another question: Do they buy bad assets at prevailing prices, in which case it won’t improve banks’ capital ratios at all, or do they defraud the taxpayer and buy back at above-market prices, as Paulson seemingly wanted to do?) It may plug a hole short term, but it doesn’t mean the banks open up and start lending again.
Washington is attempting to solve the problem by doing more of what caused the problem in the first place (and—greatest irony and travesty of all—with the very same people in charge who caused the problem in the first place, who encouraged the excesses, and who didn’t see the problem until too late). By trying to keep asset prices up, Washington is repeating the error of the 1930s and ensuring that the downturn lasts longer.
No parallel is precise, but we might look at what happened when Japan’s stock market and real estate bubbles burst at the beginning of the 1990s. The Bank of Japan slashed rates, down to ½% on long-term government bonds, and bought up bad assets from the bankrupt banks. (They didn’t open the monetary spigots, as has Washington.) Neither high interest rates of shaky banks have been a problem in Japan for many years.
But that didn’t cause banks to resume lending. Japan also increased deposit insurance (covering accounts in full until 2006.) That simply slowed the needed restructuring, and caused the banks to withdraw, as The Wall Street Journal put it, “led to the establishment of zombie banks.” There has been essentially zero net capital investment in Japan in the last 15 years. Despite near-invisible interest rates and strong banks, Japan has been in either recession of deflation (or both) for most of the past 18 years. And Japan had one huge advantage over the U.S. today, namely that households had low debt and high savings.
It’s Not Pretty Ahead
Not only will current policies not solve the problem, they protract the downturn and delay the needed resolution. But they make matters worse by ensuring more inflation, already at a 17-year high in the U.S., adding another disincentive to save. Taxes will go up, further suppressing economic growth or chances of a recovery. The likely result is a severe case of stagflation
So the economy is likely to enter a recession soon, but it will be a long and painful experience coming out of it, a protracted period of sluggishness, with other economic problems. And the market, likewise, is likely to be sluggish for some time, though once we see some stability return, specific sectors and individual companies will recover sooner, while we will see short-term rallies.
Next time, we’ll look at the outlook for various markets, including, most importantly, the dollar, and then discuss how investors should act in the current crisis (clue: don’t dump quality companies below their intrinsic value into a declining market).
Adrian Day is President of Adrian Day Asset Management, which manages portfolios in resource and global equities. Contact him at Adrian Day Asset Management, 801 Compass Way, Suite 207, Box 6643, Annapolis, MD 21401; Tel: 410-224-2037; Fax: 410-224-8229; Email Adrian Day